Update Aiding and Abetting in the Breach of a Fiduciary Duty The Appellate Decision in Sharp Electronics A Step in the Direction of Victory for Lenders
As stated in the October article, most chapter 11 debtors are more leveraged than ever before. With the increased debt leverage, secured creditors are entitled to get paid first and to receive everything. The only hope for a meaningful recovery by unsecured creditors, as well as any other junior stakeholders, is if the secured liens are avoided, secured claims are disallowed or subordinated and/or if the creditors' committee can obtain an affirmative recovery based on some lender liability theory.4 Accordingly, creditors' committees and trustees are becoming more creative and aggressive (as well as, in my opinion, aggressively creative!) with respect to actions brought in order to claim some piece of the secured creditors' pie for the benefit of the unsecured creditors.5 As part of "kitchen sink"-type complaints filed by committees or trustees to attempt to garner some sort of recovery, a claim that has evolved is a claim that the lender(s) aided and abetted in the principals' breach of a fiduciary duty, thereby causing harm to the unsecured creditors for which those creditors should be compensated. The aiding-and-abetting argument is appearing in many significant chapter 11 cases including, but not limited to, such recent cases such as Adelphia,6 Enron7 and Exide Technologies.8
Elements of Aiding and Abetting Breach of a Fiduciary Duty
Under the laws of most states where an aiding-and-abetting claim is recognized, a claim for aiding and abetting the breach of a fiduciary duty requires a showing that there (1) existed a fiduciary relationship, (2) was a breach of the fiduciary's duty, (3) was knowing participation in the breach by a defendant who is not a fiduciary and (4) are damages proximately caused by the breach.9 Furthermore, to the extent the underlying breaches of fiduciary duty are based on fraudulent conduct, the complaint must meet the requirement of Rule 9(b) of the Federal Rules of Civil Procedure, which mandates that all allegations of fraud must be pled with particularity. However, Rule 9(b)'s particularity requirement does not apply to "conditions of the mind"—including knowledge—that may be averred generally.10 For a more in-depth discussion of each of the elements and the case law discussing them, see the October 2004 ABI Journal article.11
The Sharp Case Prior to April 2005
Sharp was a closely held New York corporation that engaged in the business of importing, exporting and assembling wrist watches, clocks, pens and mechanical pencils.12 Three brothers purchased a 100 percent interest in Sharp in February 1993 and continued as the sole officers of the company through 1999. In early 1995, the brothers sold 13 percent of the company to another entity (the "purchaser"), which entitled the purchaser to a seat on the board and other corporate rights such as inspecting books and records. The brothers engaged in fraudulent conduct such as falsifying business records in order to report fictitious revenue as well as looting fraudulently raised funds and other corporate profits (to the tune of about $44 million) from sometime after 1997 and continuing through October 1999.13 The inflated revenues were used to induce lenders to extend financing to the company, and Sharp began borrowing from State Street, and others, in November 1996. Specifically, State Street approved a $20 million demand line of credit secured by the alleged assets of Sharp, and a group of investors extended $17.5 million through the purchase of subordinated notes.14
It is reported that State Street began to suspect the fraud sometime in 1998 when Sharp failed to comply with the accounting requirements under the loan documents and consumed enormous sums of cash, by virtue of the State Street officer's prior experience with another company that had engaged in fraudulent practices. Even though Sharp was current on its loan payments and State Street appeared to be oversecured, the State Street officer began to take cautionary measures in the fall of 1998, such as assigning a workout officer to the Sharp account, alerting senior State Street employees and engaging counsel specializing in troubled loans.15 State Street began to press for more detailed information, and its outside counsel engaged a financial investigation firm to assist in its examination of the business of Sharp, which produced a 60-page report confirming many of State Street's suspicions. Thereafter, State Street took heightened action in reviewing the financial reporting of Sharp and requested formal confirmations of receivables from customers.16
Shortly thereafter, State Street required Sharp to obtain new financing and pay off the debt owed to State Street. Sharp went to the subordinated noteholders for $25 million ($10 million more than it owed State Street). During this time, State Street did not share its discoveries with the noteholders, nor did it pull the plug on Sharp as it had the right to do. In March 1999, the noteholders purchased an additional $25 million in subordinated notes, and Sharp paid State Street about $12.25 million from the proceeds. The brothers also gave State Street personal promissory notes for the difference of $2.75 million.17 In July 1999, KPMG refused to issue 1999 audited financial statements and withdrew its 1997 and 1998 audit opinions. In September 1999, the noteholders commenced an involuntary bankruptcy proceeding against Sharp.18
The brothers were slapped by the bankruptcy court in November 2000 with a $44.38 million judgment and later pled guilty to criminal charges for defrauding State Street and others.19
In the complaint filed by the trustee against State Street in the bankruptcy, the trustee alleged that State Street aided and abetted the brothers in their breach of their fiduciary duties and that $19 million in damages were caused by the brothers between the time State Street first discovered the fraud and the time the bankruptcy court removed them from power in Sharp. Further, the complaint also sought recovery of the $12.25 million payment to State Street by the noteholders at a time when State Street knew of the fraud. State Street moved to dismiss the complaint. The bankruptcy court granted State Street's motion for failure to state a claim of aiding and abetting in the breach of fiduciary duties, finding that the complaint failed to plead that State Street had actual knowledge of the brothers' looting of Sharp and fraudulently raising additional funds. The bankruptcy court also found that the complaint failed to establish that, in the alternative, State Street "participated in" or "induced" the brothers' breach of their fiduciary duties.20 The bankruptcy court specifically found that the complaint failed to sufficiently identify any affirmative act of participation by State Street in the principals' fraud.21 Sharp appealed the bankruptcy court decision, and the noteholders commenced a separate action against State Street in New York County Supreme Court in which they alleged, inter alia, that State Street aided and abetted in the brothers' fraud, which was ultimately dismissed on a motion for summary judgment.22 The district court affirmed the decision of the bankruptcy court while arriving at its conclusion in a slightly different way than the bankruptcy court. Interestingly, even though the bankruptcy court and the district court opinions actually dismissed the claims against the lender, aiding-and-abetting claims began to appear with gusto in many creditors' committees' complaints against secured lenders after those opinions were issued. However, the recent decision from the appeals court, although affirming the lower courts' decisions, may curb the enthusiasm for bringing such claims.
Appeals Court Decision in Sharp: April 2005
On April 21, 2005, the U.S. Court of Appeals for the Second Circuit affirmed the dismissal of the complaint against State Street and specifically found that Sharp had not pled facts sufficient to entitle Sharp to relief under any of the legal theories advanced in the underlying complaint.23 The court noted that the bankruptcy court and district court disagreed as to whether State Street had actual knowledge of both stages of the brothers' fraud, but concluded it did not have to examine the issue since the complaint failed to sufficiently allege either knowing inducement or participation.24 The appeals court noted that the bankruptcy court had conceptually severed the brothers' conduct into two distinct breaches of fiduciary duty: (1) fraudulently borrowing funds on behalf of Sharp and (2) "looting" those funds (and others) from Sharp.25 The district court viewed the brothers' conduct as a part of a single scheme.26 The appeals court stated that it did not have to reconcile the disparate views of the two courts as to whether there were two breaches or one because damages were an essential element to the aiding-and-abetting claim and the damages alleged in the complaint were based on the $19 million looted by the brothers, not their fraudulent borrowing on Sharp's behalf.27 Accordingly, the focus of the appeals court's analysis was on whether State Street knowingly induced or participated in the brothers' looting of the company, which resulted in the alleged $19 million in damages.
The appeals court noted that inducement was the "act or process of enticing or persuading another person to take a certain course of action."28 Further, the appeals court noted that a person knowingly participates in a breach of a fiduciary duty only when he or she provides "substantial assistance" to the primary violator.29 As had been stated in other cases, the appeals court noted that "substantial assistance" does not mean mere inaction, but rather that the alleged aider or abettor "affirmatively assists, helps conceal or fails to act when required to do so, thereby enabling the breach to occur."30
All of the appeals court's discussions as to what the standards are for "knowing participation" or "substantial assistance" have been stated before by other courts. What is significant is the appeals court's application of those standards with respect to the facts of the Sharp case and, specifically, State Street's actions to protect its own best interest. The appeals court took note that there were five acts cited in the complaint that supposedly rose to the level of aiding and abetting in the brothers' breach of their fiduciary duties and ultimately concluded in a very forceful statement: "[T]he complaint says no more than that State Street relied on its own wits and resources to extricate itself from peril, without warning persons it had no duty to warn." In the court's opinion, the five alleged "acts" on behalf of State Street can be viewed as follows:
1. State Street demanded that Sharp obtain new sources of financing to pay off its own debt. The appeals court noted that even if this was true, the allegation cannot be characterized as participation or substantial assistance in the brothers' breach of their fiduciary duties. The appeals court also noted that while the demand for payment could possibly be viewed as an inducement in the broadest sense, it actually constituted no more than a demand for what it had a contractual and legal right to—repayment (even if it determined that foreclosure would not bring about repayment). The appeals court reiterated the findings of the district court in that the demand for repayment could not induce the brothers to engage in a fraud that had already begun before the demand for repayment. Accordingly, the appeals court found that "demand for repayment of a bona fide debt is not a corrupt inducement that would create aider or abettor liability."31
2. State Street deliberately concealed its knowledge of the fraud; 3. State Street elected not to foreclose on the loan; and 4. State Street avoided the noteholders' repeated attempts to reach it concerning the Sharp credit. The court included these three allegations concerning State Street's conduct in one discussion point having to do with State Street's supposed failure to act. It is important to note that the appeals court viewed these three allegations as "artful pleading." The appeals court reiterated that "substantial assistance" has to do with an affirmative assistance or assistance with concealing, and therefore failure to act, absent some other duty to act, cannot satisfy the standard for substantial assistance. The appeals court noted that it is established that the legal relationship between borrower and lender is a contractual one of debtor and creditor and does not create a fiduciary relationship. Accordingly, State Street had no affirmative duty under New York law to inform Sharp, its creditors or future creditors of the brothers' fraud.32 In the appeals court's opinion, even if State Street was hoping that a less diligent lender would take it out, "silence and forbearance did not assist in the fraud affirmatively."33
5. State Street participated in the brothers' fraud by providing consent to the noteholders purchase of the subordinated notes. The appeals court was not convinced that State Street's provision of its contractually required consent to the noteholders' purchase of the subordinated notes constituted "affirmative assistance." While in the appeals court's view State Street's consent was affirmative in that it had to write a consent, it was not "assistance" in that it was a mere forbearance: "[I]t did no more than remove a contractual impediment that was reserved to [itself] to invoke or not in its own interest." The appeals court was clear that although State Street had the right to provide consent or not, the existence of that right did not include a duty to take into account anyone else's interests but its own. The appeals court concluded that State Street's exercise of the right to provide consent (and, in turn, protect its own interest) rather than its "improvident creditors" did not constitute participation in the brothers' fraud that would warrant a finding of aiding and abetting in the breach of the brothers' fiduciary duties.34
After discussing the specific acts of State Street alleged in the complaint, the appeals court recognized that while on the one hand State Street's knowledge that there would be victims of the brothers' fraud, while ensuring they were not among them, was "repugnant;" on the other hand, the officer at State Street's discovery of the brother's fraud was an "asset" of State Street and State Street had a fiduciary duty of its own to use that asset to protect its own shareholders. The appeals court likened it to State Street failing to "tell someone their coat is on fire, or...grabbing a seat when the music stops." The appeals court acknowledged that moral analysis "contributes little." In the appeals court's view, any other diligent lender could have also found out the information about the fraud, and State Street had no obligation to blow the whistle on the fraud. Accordingly, failure to "blow the whistle" was not actionable, and State Street was not liable for aiding and abetting in the breach of the brothers' fiduciary duty.
Prof. Dan Schechter has suggested that perhaps this case walks the line and could have easily come out the other way.35 I am not sure that I agree with Prof. Schechter's conclusions.36 Perhaps State Street's actions screamed of self-preservation, and perhaps they even crossed the "moral" dividing line—specifically, allowing the noteholders to loan money to Sharp solely for the purpose of repaying State Street when it knew of the brothers' fraudulent behavior. However, I agree with the appeals court in that the noteholders had every opportunity to discover the fraud for themselves and that State Street owed them no affirmative duty to warn them or protect them from making a bad investment. Had State Street actually misrepresented the condition of Sharp to the noteholders, or denied that Sharp was in default of its obligations to State Street, then the reasoning of the appeals court would likely have led the court to conclude that State Street had engaged in an "affirmative" act rising to the level of substantial participation. It was a close line, yes, but State Street did not cross over it in a way that satisfied the standards to establish that State Street had aided and abetted in the breach of the brothers' fiduciary duties.
In the meantime, the conclusions reached by the appeals court could provide some comfort and encouragement to secured lenders who have lately been under fire from aggressive and creative creditors' committees and trustees. Most importantly, lenders can find some solace in the appeals court's determination that mere inaction by a secured lender, or actions motivated by preservation of its own best interest, will not satisfy the standard necessary to establish an affirmative act sufficient to warrant imposition of liability based on the theory of aiding and abetting a breach of a fiduciary duty. However, the reality is that it is likely that most of these claims will continue to be settled as part of a global settlement of a multiple-count complaint designed to bring about some sort of recovery where no other recovery can be had. Without settlement of these types of claims, as well as the other creative claims of late such as deepening insolvency and recharacterization, all parties understand that these types of claims are factually intensive, expensive to litigate, and may delay bankruptcy cases and, ultimately, delay the recovery to secured lenders and creditors alike.
1 Ms. Brighton is special counsel with Kennedy Covington Lobdell & Hickman, Charlotte, N.C., in the Debt Finance Group, where she practices primarily in the area of bankruptcy, workouts and secured lending. She serves on the ABI Journal Editorial Board and is certified in Business Bankruptcy by the American Board of Certification. Return to article
5 In another article published in the ABI Journal, I stated that deepening insolvency was also a tool that had been added to the creditors' committee's toolbox and that now appears as a standard part of the "kitchen sink" complaint filed by creditors' committees in chapter 11 cases. See Brighton, Jo Ann J., "Deepening Insolvency - Secured Creditors and Professionals Beware: It Is Not Just for Officers and Directors Anymore," ABI Journal, Vol. XXIII, No. 3 (April 2004). Return to article
8 In re Exide Technologies Inc., 299 B.R. 732 (Bankr. D. Del. 2003) (court determined creditors stated claim against lenders for aiding and abetting debtor's breach fiduciary duty and parties ultimately settled). Return to article
10 F.R.C.P. 9(b); Sharp, 302 B.R. at 770. See, also, expanded discussion of "heightened specificity" required for F.R.C.P. 9(b) and aiding and abetting claims; Neilson v. Union Bank of California N.A., 290 F.Supp.2d 1101, 1129-30 n. 81 (C.D. Cal. 2003). Return to article
19 Id. See Albion Alliance Mezzanine Fund L.P. v. State Street Bank & Trust Co., 2003 N.Y. Misc. LEXIS 1557, *7, No. 602711/01 (N.Y. Sup. Ct. Apr. 14, 2003) aff'd., 2 A.D.3d 162, 767 N.Y.S.2d 619 (1st Dep't. 2003). Return to article
22 Id. While the appeal was pending, the New York court dismissed the complaint against State Street on a motion for summary judgment finding that nothing in discovery revealed any conduct by State Street that was more serious than that conduct alleged in the adversary proceeding. Albion, 2003 N.Y. Misc. LEXIS 1557 at *17-18, aff'd., 2 A.D.3d 162, 767 N.Y.S.2d 619 (1st Dep't. 2003). Return to article
36 Prof. Schechter states that the court in Neilson v. Union Bank of California N.A., 290 F.Supp.2d 1101 (C.D. Cal. 2003), reached a different conclusion on the same facts. Id. I would disagree in that the Neilson court was presented with facts analyzed under California law—where substantial assistance doesn't require the "affirmative" act required under New York law, but rather that the actions of the aider/abettor proximately caused the harm on which the primary liability is predicated. Neilson 290 F.Supp at 1129-30 (other citations omitted). Accordingly, the court in Neilson found that the bank's provision of cash upon which the Ponzi scheme of fraud was funded met the standard of proximate cause. Further, in that case, there were allegations that defendants made affirmative statements misrepresenting the financial situation of the company and the classification of its assets to investors as well—as vouching for the person committing the primary violation. Id. at 1130-31. State Street may have walked the line by refusing to respond to inquiries, but in Sharp, no affirmative misrepresentations were alleged. Return to article